More Debate On Glass-Steagall

This past weekend's Wall Street Journal published an editorial by Charles W. Calomiris, a Columbia Business School professor, entitled, "Most Pundits Are Wrong About the Bubble."

In his piece, Calomiris contends,

"As for the evils of deregulation, exactly which measures are they referring to? Financial deregulation for the past three decades consisted of the removal of deposit interest-rate ceilings, the relaxation of branching powers, and allowing commercial banks to enter underwriting and insurance and other financial activities. Wasn't the ability for commercial and investment banks to merge (the result of the 1999 Gramm-Leach-Bliley Act, which repealed part of the 1933 Glass-Steagall Act) a major stabilizer to the financial system this past year? Indeed, it allowed Bear Stearns and Merrill Lynch to be acquired by J.P. Morgan Chase and Bank of America, and allowed Goldman Sachs and Morgan Stanley to convert to bank holding companies to help shore up their positions during the mid-September bear runs on their stocks."

I disagree. Calomiris' retroactive judgment of the repeal of Glass-Steagall suggests that, even if it was a mistake, its absence let the mess which developed in its absence be cleaned up in a manner which would not have been quite so neat without its absence.

Sound like circular reasoning to you? Me, too.

No, as I wrote here in March of this year, the true effects of Glass-Steagall's repeal were slower to observe. But Gerry Weiss, my boss and one-time SVP and Chief Planning Officer of Chase Manhattan Bank for David Rockefeller, noted this in the 1980s. As I wrote in that post,

"My long-ago mentor at Chase Manhattan Bank, then-SVP of Corporate Planning & Development, Gerry Weiss, was fond of saying, when asked about working to remove Glass-Steagall, something like,

'Are you kidding? We'll just find some new ways to lose a lot of money on badly risk-managed positions. Not to mention that, being commercial bankers, once we get into these businesses- M&A, underwriting, equity trading- we'll cut prices to gain share and ruin the business' profitability for all concerned.'

Judging by the behavior of Citigroup and BofA in last summer's CDO, SIV and other fixed income messes, I'd say he was right on the money, as it were, as usual.

Commercial banks appear to be no better off in terms of profitability, risk management or total return after the repeal of Glass-Steagall."

It was this effect of the repeal of Glass-Steagall on the commercial banks, not the investment banks, which began the slide into our current mess.

In fact, to illustrate that investment and commercial banks were misbehaving, and losing money, with respect to mortgages long before our current financial crisis, consider what happened with Norwest Bank's large mortgage business, in conjunction with Salomon Brothers, back in the 1980s.

Norwest ran a huge mortgage lending and securitization pipeline, or 'conduit.' The latter was known as "RFC," for Residential Funding Corporation. Norwest owned RFC, but Salomon distributed the resulting securities because, at the time, it was illegal for Norwest to do the securities underwriting itself.

As such, Salomon enjoyed a sweet margin on the securitization, with no asset risk on the pipeline. But it was largely understood throughout the industry that RFC was structured and operated with guidance from Salomon.

At some point, RFC mishedged its enormous inventory of mortgages, and doubled up on an interest rate bet, rather than hedged it. Subsequent losses sank Norwest as an independent bank, while Salomon managed to scoop up RFC for a pittance.

Calomiris goes on to contend,

"Even more to the point, subprime lending, securitization and dealing in swaps were all activities that banks and other financial institutions have had the ability to engage in all along. There is no connection between any of these and deregulation. On the contrary, it was the ever-growing Basel Committee rules for measuring bank risk and allocating capital to absorb that risk (just try reading the Basel standards if you don't believe me) that failed miserably. The Basel rules outsourced the measurement of risk to ratings agencies or to the modelers within the banks themselves. Incentives were not properly aligned, as those that measured risk profited from underestimating it and earned large fees for doing so."

Once again, I disagree with his contention regarding the effect of deregulation on various activities.

Why do you suppose, prior to the repeal of Glass-Steagall, no investment banks engaged in buying and operating mortgage underwriting banks? Or creating large, highly-leveraged mutual funds investing in mortgage-backed securities?

Again, I point to Weiss' prescience on the consequences of removing that regulatory barrier. The subsequent thinning of investment bank profit margins led to these non-deposit funded companies boosting leverage to previously-unheard-of levels, in an attempt to maintain profit margins and growth.

Ironically, the lenders of this highly-leveraged money were.....commercial bank broker-dealer desks!

So Calomiris is wrong to suggest that all of what has transpired since the repeal could or would have happened anyway.

Structurally, investment banks could always do what commercial banks did, except for having access to the Fed window and offering DDA accounts. The repeal of Glass-Steagall drove the weaker-capitalized players, i.e., investment banks, to take more risks.

Calomiris ends with the contention,

"The single most important reform that is needed is the restoration of discipline in the measurement of risk within the banking system."

He's probably correct in this sentiment. The problem, of course, is how to define, measure and calibrate 'risk' in such a broad context.

Particularly when so much of the time, 'risk' can morph from, say, instrument to counterparty risk in the blink of an eye.

We're a long, long way from being able to rely on risk measurement on the panacea to solve our financial market problems.